Turkish uncertainties worry investors

Key takeaways

• 2019’s Turkish local elections have increased political uncertainty
• The worsening economic fundamentals include high foreign debt obligations and slowing foreign direct investment
• The central bank’s credibility has been undermined
• The TRY has fallen 12% year-to-date, making it the worst performing emerging currency of 2019
• We estimate USDTRY is still 7% overvalued. Uncertainties make further TRY declines probable 
• Until the central bank recovers credibility, we see no fundamental argument for exposure to Turkish assets. 

Unexpected setbacks for Turkey’s President Recep Tayyip Erdogan’s party in local elections on 31 March and the subsequent political turmoil are focusing attention on the country’s economic fragility, and investors are asking more questions over the central bank’s independence and weak currency.

Last year Erdogan secured a second five-year presidential mandate, but tensions with the US over the detention of an American pastor followed that victory. Combined with investors’ concerns about the underlying economic weaknesses, a potential loss of central bank’s credibility and rising US yields, this triggered a collapse of almost 50% in the Turkish lira (TRY) between the end of June and mid-August 2018.

This year’s elections have divided Erdogan’s alliance with nationalists as the parties blame one another for the local losses and appeal against the result in Istanbul, prolonging the political instability.

Turkey’s GDP growth averaged 7% over the 18 months from January 2017, thanks to cheap foreign borrowing and robust domestic credit growth. However, that came at the cost of rising private sector debt and widening current account deficits. We began warning about Turkey’s difficult economic environment in late 2017.

Rating agencies Moody’s and S&P both cut their long-term issuer ratings in August last year and tellingly, kept their outlooks negative. Credit default swap (CDS) spreads, a measure of investor confidence that the country will repay its debt, spiked from a low of 313 basis points in mid-March before the election to a year-to-date high on 26 April of more than 463 bps (see chart 1). The Turkish 10-year May 2019 government bond is currently offering a yield of 18.7 percent.

The worsening fundamentals include worryingly high foreign debt obligations (short-term claims and interest payments), which for this year amount to USD 180 billion. In parallel, foreign direct investment has slowed to a trickle of USD 10 billion, or just 1.2% of GDP. This leaves the country increasingly reliant on more volatile financial portfolio inflows and leads investors to demand a higher risk premium in return.

Credibility and the overvalued lira

Last year investors were relieved that the Turkish central bank (CBRT) raised interest rates in mid-September from 17.5% to 24%, limiting inflation and trying to halt a run on the currency.

Investors now fear that, not for the first time in recent years, the independence of the CBRT is slipping away. Last week it abandoned its interest rate tightening language, despite inflation remaining close to 20% year-on-year (down from a 25% peak).

The central bank may have carried out some surreptitious easing in March ahead of the local elections, the Financial Times reported on 18 April. The market interpreted the CBRT as trying to conceal this with less-than-transparent communication. The fall in foreign exchange reserves leaves inadequate resources to defend the currency from another speculative attack (see chart 2).

Further undermining the CBRT’s credibility, the TRY has reacted by falling 12% year-to-date, making it the worst performing emerging currency of 2019. Our fair value model suggests that the Turkish currency is still 7% overvalued. Over this year, the oil price has rallied 35%, which is key for Turkey as a major importer, storing up inflation pressures for the future.

Turkey’s position at the crossroads of Asia and Europe has historically made it a geopolitical buffer. Strategic tensions with the US have now intensified over Turkey’s purchase of a missile defence system from Russia, which is incompatible with NATO’s collective hardware. In response, the US has threatened sanctions against Turkey and even talked of cancelling the country’s participation in the 20-year development of a new fighter aircraft. The strain between the two traditional NATO allies has done nothing to reassure investors.

In short, the country’s currency reflects its political and economic weaknesses. While the TRY has undoubtedly already priced in a host of bad news, there are still enough uncertainties to make further declines probable. Until the political landscape settles and even more importantly, the country’s central bank recovers credibility, we see no fundamental argument for exposure to Turkish assets.